Showtime’s drama series “Dexter” is one of my favorite TV series.
The series centers on Dexter Morgan, a forensic tech specializing in blood spatter analysis for the Police Department, who leads a secret life as a vigilante serial killer, hunting down murderers who have slipped through the cracks of the justice system. Dexter has what he calls a “dark passenger,” which is his need to kill.
“Monkey in a Box” was the second to last episode of the series. This episode finds Dexter, trying to clean up his situation in Miami so that he can escape to Argentina with his young son and his girlfriend, before the law can get to him. All 2 million viewers are watching and wondering if he’s going to make it to Argentina.
After 8 years will Dexter finally be free to live a normal, happy life unencumbered by his “dark passenger?”
In a similar way, the world is watching and wondering if the Fed will continue to raise rates and in so doing, ween the markets off of their dark passenger, which is the need for loose monetary policy and 0% interest rates. While the parallels aren’t precise, make no mistake about it, the Fed is the monkey in a box. Being SHORT US equities is the way to benefit from that monkey’s predicament.
Last week’s Fed announcement reconfirmed for me that, at this point, the Fed is making it up as they go along. Chairman Yellen acknowledged that the Fed’s assessment of the US economy hasn’t changed much since December. Then she proceeded to cut the number of possible rate hikes in 2016 in half and substantially change the language in the forward guidance to dovish.
Now, most people weren’t expecting a rate hike but based on the latest inflation numbers reported last week, I at least expected the Fed to begin to prepare the markets for more rate increases shortly. However, this didn’t materialize.
The latest CPI data, minus energy and food, showed the highest annual growth rate in 8 years. Headline inflation is still running low but CPI tends to lead and so it's predicting that headline inflation will soon be on the rise as well. 5-year inflation expectations from market participants also has risen to the highest in a year.
I don’t understand why we track a “consumer” inflation number that doesn’t include energy and food costs. Basically CPI is an inflation measure for consumers who don’t drive, don’t heat their houses and don’t eat. There is no value in this, except that the Fed uses this measure to make decisions. And as such, it is critical that we monitor it. Now back to our regularly scheduled programming.
The Fed’s rationale for cutting the number of proposed hikes and changing its language was “global growth concerns and financial market volatility.” Don’t be confused, there was plenty of global growth concerns and financial market volatility to go around back in December when the Fed raised rates the first time.
The only difference between the world in December and the world last week is the amount of volatility experienced by the US equity market. I’ve been on the record that I don’t think the Fed will raise rates at all this year and that they will be forced to ease again in early 2017. I stand by that statement but I am allowing a small probability of a rate hike in June. But if the Fed doesn’t raise in June, it ain’t happening.
The markets reacted swiftly to the Fed’s announcement, none more so than the US Dollar. The USD lost over 1% 2 days in row for the first time in years. It’s decline sent everything commodity-related soaring.
In the last 2.5 days of the week, commodity indices gained over 2%, oil gained 7%, material, energy and industrial stocks gained over 3%. Even stodgy sectors like utilities and consumer staples gained over 1%.
But there was one market that was mysteriously absent from the post-Fed announcement soiree, the broader US equity market as measured by the S&P 500. All that the S&P could muster in response to the Fed was a muted rally that simply ended with yet another lower high being made. What this means is that the downtrend in US equities that began with the S&P peaking in early November is still solidly intact.
By contrast, look at a chart and there are a number of US equity sectors performing well. Material stocks are trading higher than November and on the verge of breaking to 12-month highs. Industrial stocks are trading at the highest level since last June and just broke out above a critical area of resistance. Utility and Consumer staples stocks are trading at new all-time highs.
Yet the broader US equity market is still struggling, pulled down mainly by financial and healthcare stocks. Depending on how the S&P trades over the last 9 trading days of this month, March could be the fourth consecutive month with a lower high being made. Here are the highs for the last 4 months starting with November: 2116, 2103, 2038, 1958. That said, the S&P is trading at 2049 currently but in the context of its current downtrend, that’s just another lower high.
It's true that the S&P has been on a tear, rallying 13% since bottoming on February 11. However, there are a couple of behavioral aspects of the US equity market that have the probabilities leaning towards this current rally ending and the market rolling over.
The first aspect is the buying and selling activity of investors. Based on data tracked by Bank Of America-Merrill Lynch, institutional clients, hedge funds and even private clients have been net sellers of US equities for 7 consecutive weeks. Smart money and dumb money alike have used the recent rally to lighten up their exposure.
If everyone is selling, how is the market being pushed higher? This brings us to the second behavioral aspect of the market worth paying attention to, corporate buybacks. Juxtaposed against investor behavior, companies in the S&P 500 are on pace to buy back $165B worth of stock in Q1.
This amount is approaching the single quarter record set in 2007. This buying also highlights the divergence from the Bank of America data, as well as recent mutual fund data which shows net outflows from US equity mutual funds of almost $40B so far this quarter. This shows just how crucial buybacks have been to the S&P’s current rally.
Now for the troubling news if you’re a US equity bull. The buyback window is closing, as is mandatory, 1 month ahead of earnings season. In 4 of the last 8 quarters, the S&P has declined in the month leading up to earnings. The average return during that month was just 30 basis points as compared to a 1.6% average return during earnings season itself and the month after earnings were announced.
These behavioral aspects coupled with the S&P’s quantitative set-up are why I went SHORT the SPDR ETF, SPY, in the Trade Commentary Section of the last week’s TWR. We used SPY’s muted post-Fed rally to initiate a SHORT trade idea at Thursday’s closing price of $204.63.
Even if the SPY can muster a rally towards previous all-time highs, that's just 2.5% from here. There’s at least 5% of downside from Friday’s close. Reward to risk of 2:1 and the probabilities of success heavily tilted in our direction? Sounds like Argentina to me.